The Fed's 50-point rate cut poses risks for retirees

By Brett Arends

Will inflation stage a comeback?

To hear some people talk, you'd think the Federal Reserve just cut all the interest rates across the economy.

It didn't. Not even close.

The Fed has only cut short-term rates, known as the fed-funds rate. It's up to the bond market-millions of people, investing trillions of dollars-to move all the other interest rates, including Treasury bond yields, corporate bond yields, mortgage rates, and annuities.

And so far, it's been a mixed bag.

The interest rate on the 10-year Treasury note BX: TMUBMUSD10Y fell as low as 3.62% just before the Fed news.

Today: 3.79%.

The rate on BAA-rated investment grade corporate bonds was 4.85% before the Fed's move, according to FactSet.

Now: 4.89%.

And 10 year inflation-protected Treasury bonds were paying 1.54% plus inflation before the Fed.

Now: Inflation plus 1.61%.

Some "cut."

The Fed's move raises risks and opportunities for retirees and other older investors. That's because we typically have more of our money in (so-called) lower risk bonds than younger investors, and less in more volatile stocks.

(For instance one widely-used rule of thumb is that the percentage of your portfolio that you should have in stocks is 120 minus your age: so if you're 50 you'd have 70% in stocks and 30% in bonds.)

The stock market, so far, loves the Fed's deep 50-point cut in the fed-funds rate.

The bond market: Not so much.

Larry Glazer, portfolio manager at Mayflower Financial Advisors in Boston, says the bond market is worrying about two things now. One is "the soaring debt, which looks like it will only escalate regardless of the outcome of the election," he says. The other? "Inflation" - or, even worse, "or potentially "the dreaded stagflation that is almost unimaginable."

JP Morgan Chase CEO Jamie Dimon has recently been warning (again) about the risks of inflation or stagflation.

Inflation is a major hazard for bondholders. It is one thing to lend your money to Uncle Sam for 10 years at 3.8% interest if prices end up rising by just 1.8% a year, as they did from 2010 through 2019. If that happens, you make about 2% a year in "real" spending power terms.

It's a different story if prices end up rising, say, 7.4% a year, as they did in the 1970s. If that happens, you lose money. Badly.

This is the difference, as Charles Dickens's character Wilkins Micawber famously said in "David Copperfield," between financial "happiness" and "misery."

Where are we now?

Ominously, the bond markets are now more nervous about inflation than they were before the Fed's move. Inflation expectations, which were plummeting in the weeks before the Fed announcement, have now leveled off, and in some cases started to rise.

(The bond market's inflation forecasts can be found by comparing the interest rates on bonds that have inflation protection with the interest rates on bonds that don't.)

Shortly before the Fed cut, the 10-year inflation forecast was down to 2.02%-almost exactly in line with the Fed's official 2% target.

Now: 2.17%.

Jerome Powell spent several years vowing to do whatever he had to do to get inflation down to 2% and convince the bond market he had the mettle to keep it there.

By early September the bond market, at long last, finally believed him. Now? They're not quite so sure.

This raises risks for anyone owning bonds.

At this stage, the interest rates offered on most bonds are pretty low by historical standards. Meanwhile the long-term inflation outlook may not be as sunny as it seemed.

According to data tracked by New York University's Stern School of Business, since the 1920s investors in 10-year U.S. Treasury bonds have earned an average return of around 1.9% a year on top of inflation, and investors in BAA investment grade corporates 3.8% a year on top of inflation.

You'll only get those kinds of returns from bonds today if inflation expectations fall. Instead, they've ticked up.

Shorter-term bonds face lower inflation risk (as do inflation-protected bonds). Low cost options for these include Vanguard Short Term Bond BSV, with a current yield of 3.9%, the Vanguard Short Term Corporate Bond ETF VCSH with a yield of 4.4%, and the iShares 0-5 Year TIPS Bond ETF STIP, with a real (inflation adjusted) yield of 2.1%. If the bond market view of the Fed sours any further, longer term bonds will prove riskier than many hope.

-Brett Arends

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09-24-24 1156ET

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